Fighting the pain of our Big Dollar

The shockingly bad trade deficit result for August shows why everybody including the Reserve Bank wants the Australian dollar to do what it has always done in the past, and follow commodity prices down in lockstep. The problem is, it can't.

The trade result was bad enough to send the $A a bit further in the desired direction. It slipped about a quarter of a US cent as soon as the deficit number was out, taking its decline since the Reserve Bank cut its cash rate from 3.5 per cent to 3.25 per cent on Tuesday afternoon to about US1.3¢.

The dollar was as high as $US1.06 in mid-September after US Federal Reserve chairman Ben Bernanke announced another round of quantitative easing that will lower US rates and the value of the US dollar, and it may fall

further if the Reserve Bank, as expected, cuts rates again to buttress the economy.

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The currency's sensitivity to commodity price falls is going to be dulled for years by its newfound status as a safe-haven high-yielding currency, however, and there's next to no chance that the central bank will intervene directly.

The market consensus was that Australia would post a $670 million trade deficit in August. Instead, the deficit was $2.03 billion as exports fell 3 per cent to be $3.4 billion lower than they were a year ago, and the estimate of the deficit for July was increased from $556 million to $1.53 billion.

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The trade deficit is blowing out because Australia is caught in a currency-commodity trap. Export revenue is falling as prices decline and volumes ease (iron ore export volumes were up in August but coal volumes were down), and the $A is not falling fast enough to produce an offsetting currency exchange gain as $US commodity revenue is translated into Australian dollars.

The high dollar has also been sucking in imports: they fell by 1.3 per cent in August compared with July, but are still 6 per cent higher than they were a year ago.

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The Reserve Bank's commodity price index tracks Australia's key commodity exports, and it fell by 1.3 per cent in September to be down 14.9 per cent in a year. The Australia dollar on the other hand was almost 8 per cent weaker against the US dollar a year ago than now, and the trade-weighted currency index has not moved.

In the good old days, our dollar and commodity prices danced together in a tight embrace. Interest rate relativities didn't elbow in significantly, and neither did the credit ratings agencies: Australia paid a bit more for debt between 1986 when it lost its triple-A credit rating and 2003 when it won it back, but the change affected pricing rather than the actual flow of money, because all the big Western currencies were highly rated.

Commodity prices still count, but the other two factors are much more important than they were before the global crisis changed the world. We have a Big Dollar now, one of about a dozen with an unqualified triple-A credit rating, and the one that offers the highest yield even after offshore buying has basically halved the yield in a year and a half.

US government 10-year bonds are yielding about 1.6 per cent, and short-term US government paper is yielding next to nothing. Bonds of up to two years' duration issued by Europe's unsullied triple-A six - Germany, Denmark, the Netherlands, Finland, Switzerland and Austria - actually went onto negative yields in July and are still barely in positive territory.

Australia's triple-A yields - 2.35 per cent on two-year Commonwealth government debt, say, and 2.9 per cent on 10-year Commonwealth debt - are solid gold compared with that, and overseas investors including central banks have been buying.

There have been calls for the Reserve Bank to do something - anything - to pull the value of our Big Dollar down, but the Swiss National Bank's decision a year ago to put a lid on the value of the Swiss franc by printing francs and selling them en masse is highly unlikely to be replicated here.

The $A distinguishes itself in the world as being one that trades without interference. It is part of Australia's branding as a modern, free-market economy - and the flip side of the Swiss National Bank's Swiss franc selloff is that it is buying other currencies. Its foreign currency reserves have risen from 255 billion francs to 421 billion; depending on what exchange rate it targeted, our central bank could need to buy even more.

The Reserve can nibble at the edges of the problem by cutting its cash rate. It will be mainly aiming to boost economic activity in the non-resources sector to give it a better chance of stepping up as the resources boom slows, but a weakening in the value of the $A would be a welcome component of the plan.

Foreign buyers of the currency are exposed to some currency risk as the Reserve pulls rates down and the yield gap between our bonds and its overseas peers narrows, but the jaws can't completely close soon. The de-leveraging of Europe and the United States will take decades, and central banks will keep rates (and their currencies) abnormally low while it occurs, to create offsetting stimulus.

We will have a strong currency for years, and it will be a test of our mettle and ability to adapt and increase our productivity, just as deregulation of the exchange rate and interest rates and the reduction in trade barriers were in the '80s and '90s. We took the medicine and did what was needed then: we have to do so again.